Fixed Income

October 2, 2013

Commentary

February 5, 2014

The Odd Couple

Felix Ungar: “In other words, you're throwing me out.” Oscar Madison: “Not in other words. Those are the perfect ones!”

A neat freak and a slob are never going to make the best of roommates; they are incompatible. From the beginning of the show we all knew it was just a matter of time before they would go their separate ways; yet the pairing of two polar opposite characters was great fun to watch.

Fast Read……

• January was a positive month for fixed income markets, despite firming data and continued Fed “taper” action. • Interest rates should rise as economic growth continues. • However, the large number of economic variables makes the timing of higher rates uncertain. • Our strategy continues to favor intermediate duration targets and higher yields as ways to protect principal and earn income in today’s choppy markets

An improving economy and falling interest rates are generally an odd couple, but this was the story line in January. Many economic indicators suggest US and world economies will grow faster in 2014 than in 2013, despite reductions in monthly bond purchases by the Federal Reserve. Yields continued to fall even after the Fed affirmed its intent to further reduce QE actions from $75 billion to $65 billion per month at its January meeting. Despite decent growth prospects, the yield on the ten year Treasury fell 38 basis points in January, a move usually due to sluggish economic growth or market distress.

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With rates falling, January was a very good month for most fixed income investors. The Barclays Aggre-gate Index gained 1.48%, versus a loss of 3.36% on the S&P 500 Index. Most fixed income asset classes shared in the gains, as shown in Chart 1.

Alas, the incompatible forces of growth and low interest rates must eventually part ways. Markets are forward looking, which implies the drop in rates occurred in anticipation of an economic slowdown. We believe the recent fall in interest rates reflects a “flight to quality” as investors seek safety amid worries about emerging market economies, financial market instability and a lackluster earnings season. Eco-nomic growth both here and abroad remains positive, albeit weaker than normal post-recession rebounds. We believe this modest growth when combined with the effects of the Fed taper will exert an upward pressure on longer term rates.

Our forecast is for slow but steady economic growth in the developed world along with continued reductions in bond purchases by the Federal Reserve. The one variable that could keep rates low despite stronger growth is low inflation. Central banks are very fearful of deflation and should continue to keep shorter term rates low for the foreseeable future, even if growth rates suggest they should do otherwise. Chart 2 shows inflation remains low in the US, Europe, Japan and China and could slow further. There is less risk from true monetary tightening with such little pressure from inflation.

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Chart 1 – Price Action for Major Fixed Income Classes

Source: Bloomberg

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Low inflation has added significance in this environment. Central bankers have a strong incentive (and the freedom) to keep accommodative policies in place as they seek to avoid deflation. These efforts to keep short term rates low and market pressures to take longer term rates higher have caused the yield curve to steepen in recent months. A steeper curve increases the rewards for investors who purchase longer dated securities, potentially offsetting some of the pain of rising rates. Chart 3 shows just how wide the Treasury curve is on a historic basis.

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Chart 2 – World Inflation is Contained

Source: Bloomberg

Chart 3 – Maturity Spreads (2-yr/10-yr Treasury) Remain Wide

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Source: Bloomberg

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October 2, 2013

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Strategy – Credit Risk and Yield Curve Management are Preferable to Interest Rate Exposure

This continues to be a challenging macro environment for fixed income portfolios. Strategically, our core forecast is for rates to rise modestly in 2014 as taper continues and the economy improves. Howev-er, we also believe the Fed will be quick to resume aggressive bond buying if higher rates have a nega-tive impact on the economy. Watching the Fed remains an important activity for market participants.

We believe chasing yield by extending duration is a risky move at this time. However, the yield curve is very steep, and hiding in short term maturities may be even more detrimental than extending maturities to increase yield.

There is a significant sweet spot in the intermediate segments of the market, although the actual range of value will vary by market sector. These maturities offer a significant yield pick up over shorter term assets but are partially protected from rising rates because they “roll down the yield curve” as their maturity dates shorten. We continue to take advantage of this yield curve positioning.

As we noted last month, credit risk continues to be an attractive way to add value. An improving economy, abundant liquidity and an accommodative Fed all provide support for credit based bonds. We are comfortable having more exposure to credit risk (i.e. buying lower rated bonds) than under normal market circumstances.

We are optimistic about the risk/reward trade off in client bond portfolios. Security selection and yield curve management should mitigate some of the interest rate risk facing investors. In addition, we continue to explore new ideas to generate returns and mitigate risk. We are pursuing opportunities as investment guidelines allow. In some cases, this has included an increased exposure to low duration preferred stock and hybrid securities, and the inclusion of stocks that act like bonds (including REITS, mortgage REITS and Business Development Corporations) and Master Limited Partnerships (MLP).

We look forward to discussing these ideas in greater detail.

Please call us with questions and comments.

Maple Capital Management, Inc.535 Stone Cutters Way, Montpelier, VT 05602 • Tel: 802.229.2838 • Toll Free: 800.255.9946 • Fax: 802.229.2837

533-D Johnson Ferry Rd • Suite 350 • Marietta, GA 30068 • Tel: 770.693.7690• Fax: 770.693.7916

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